Chapter 13 – Private Sector Components of Aggregate Demand Read pages I Determining the Level of Consumption A)Consumption and Disposable Personal Income. 1) Disposable Personal Income is the income that people have available to spend on goods and services. 2) The relationship between consumption and disposable personal income is called the consumption function.

3) The marginal propensity to consume (MPC) is the change in consumption one expects for a one unit change in disposable income. a) Example: MPC = $400/$500 =.8 b) It is the slope of the consumption function. 4) Personal savings is disposable personal income not spent on consumption during a particular period.

a) Personal savings =disposable income – consumption. 5) The savings function relates personal saving in any period to disposable personal income in that period. 6) The ratio of the change in personal savings to the change in disposable personal income is the marginal propensity to save. a) Example: MPS = $100/$500 =.2 b) The marginal propensity to save is the slope of the savings function.

C) Current versus Permanent Income 1) The current income hypothesis holds that consumption in any one period depends on income during that period (alone). 2) Permanent income is the average annual income people expect to receive for the rest of their lives. 3) The permanent income hypothesis assumes that consumption in any period depends on permanent income.

D) Other Determinants of Consumption 1)Changes in real Wealth – an increase or decrease in stock and bond prices makes holders of these assets wealthier or poorer and they would be likely change their consumption in response. 2) Changes in expectations – consumers are more willing to consume when they are optimistic about the future.

II The Aggregate Expenditure Model A)The aggregate expenditure model relates aggregate expenditures, which equal the sum of planned levels of consumption, investment and government purchases and net exports at a given price level to the level of real GDP.

B) The Aggregate Expenditure Model: A simplified View 1) We will only included investment and consumption. 2) The level of investment firms intend to make in a period is called planned investment. 3) Unplanned investment is investment during a period that firms did not intend to make. Typically consists of changes in inventories.

C) Autonomous and Induced Aggregate Expenditures. 1) Expenditures that do not vary with the level of real GDP are called autonomous aggregate expenditures. 2) Expenditures that vary with real GDP are called induced aggregate expenditures.

D) Autonomous and Induced Consumption Consider the consumption function C = $300 Billion +.8Y 1) Autonomous consumption is $300 Billion. 2) Induced consumption is.8Y

E) Plotting the Aggregate Expenditure Curve. Assume planned investment is entirely autonomous: Ip = $1,100Billion. AE = C + Ip = $300 B +.8Y +$1,100 B = $1,400B +.8Y 1) If Y=$6000 B, then AE = $6,200 B F) The Slope of the Aggregate Expenditure Curve equals the marginal propensity to consume.

F) Equilibrium in the Aggregate Expenditure Model 1) Equilibrium occurs when aggregate expenditures equals aggregate supply, AE=AS. 2) The possible equilibrium can be graphed as a 45 degree line. 3) The observed equilibrium occurs where the observed AE curve crosses the 45 degree line.

G) Changes in Aggregate Expenditures: The Multiplier. 1) Consider the previous model, but assume that planned investment expenditures increases to 1,400 B. The new AE = $300 B +.8 Y + $1,400 B = $1,700 B +.8Y The new equilibrium occurs when AE=Y, or at $8,500 for an increase of $8,500-$7,000= $1,500. Thus a $300 increase in spending resulted in a $1,500 increase in GDP for a multiplier of 1,500/300=5.

2) The domino effect of a spending change can be illustrated by Exhibit ) The multiplier is related to the marginal propensity to consume by Multiplier = 1/(1-MPC) Example: In the example MPC=.8, so Multiplier = 1/.2 = 5

H) Application of the Aggregate Expenditure Model to a More Realistic View of the Economy. 1) In a model in which taxes take some of the additional income, disposable income does not increase by as much in each successive round and thus the multiplier is smaller. 2) Government spending and net exports become part of autonomous spending.

3) This differences make the AE curve somewhat flatter and have a higher intercept. 4) The flatter curve implies a smaller multiplier and can be illustrated in the following diagram.

III Aggregate Expenditures and Aggregate Demand. A) Aggregate expenditure curves and price levels. 1) Consider an initial price level of p=1.0 as our reference point. This induces a demand for goods in our diagram of $6,000. 2) Next consider a higher price level of p=1.5. Due to a negative wealth effect, expenditures will be lower inducing a demand of $2,000. 3) Next consider a price level of p=.5. Due to a positive wealth effect, expenditures will be higher inducing a demand of $10,000. 4) These produce a downward sloping demand curve.

B) The multiplier and changes in Aggregate Demand. Any change in autonomous aggregate expenditures shifts the aggregate demand curve. The amount that it shifts equals the change in autonomous aggregate expenditures times the multiplier.